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6 April 20224 minute read

Old dog, new tricks: Direct lending in the US

The US direct lending market may be more mainstream than its European cousin but was far from dull, enjoying its biggest year ever in 2021.

Fundraisers in the US direct lending market pulled off a remarkable feat in 2020. As panic set in around the world and businesses battened down the hatches, private debt managers celebrated a stand-out year.

A total of 36 US direct lending funds secured a final close during the first year of the pandemic, amassing USD43 billion between them, comfortably topping 2019, according to Debtwire data. Building on this success, momentum has continued seemingly unabated. In 2021, 41 funds collected a total of USD71 billion. This represents respective gains of 14% and 65% on 2020 and is an all-time high for the industry, largely thanks to a handful of mega funds.

If Europe has come of age, the US has long since made that journey. The strategy of the largest US fundraise of the past two years speaks to this maturity. Apollo Global Management partnered with Emirati sovereign wealth fund Mubadala Investment Company in 2020 to set up a USD12 billion direct loan pool. Rather than target the middle-market that constitutes the core of direct lending activity, Apollo Strategic Origination Partners is aiming to issue loans valued at upwards of USD1 billion, placing it firmly in megadeal territory once equity and the potential for additional leverage are accounted for.

Certainly, the US stole a march on Europe. Across the Atlantic, direct lending had already been a familiar feature of the leveraged buyout market before the global financial crisis hit. In the 20 years between 1998 and 2018 the number of commercial banks in the US declined by around 50%, according to figures from the Federal Deposit Insurance Corporation. A wave of consolidation among regional banks gave rise to a growing pool of national lenders that focused their services on larger clients at the expense of middle-market borrowers. Fund managers stepped up to capitalise on this financing supply gap.

Pandemic period

And then along came the pandemic. Banks are as risk-averse as ever and monetary policy, including government bond purchasing, has stretched to a magnitude never seen before, amplifying existing drivers.

Following an extended bull run from 2009 to 2020, direct lenders have now proven their mettle through the pandemic. Private credit default levels never rose above 2% throughout 2020, according to Adam Street Partners, while by Q3 2020 default rates among leveraged loans reached above 4% and high-yield bonds even higher at 10% during that painful period. The industry has been cycle-tested.

That's the downside. On the upside, direct loans also continue to outperform. "Investors searching for yield were increasingly attracted to the direct lending opportunity given the low volatility and significant current income distributions," says Blair Jacobson, partner and co-head of European credit for Ares Management.

Now, in 2022 spreads are showing signs of widening in anticipation of the Fed beginning to raise the interest rate from March onwards. In this inflationary, monetary-tightening context, investors in direct lending funds that deal in floating-rate loans can take comfort from their reduced interest rate risk exposure.

And there is unlikely to be any shortage of demand for loans. PE fundraising and collective firepower far outmatches that of private lenders. Estimates vary, but as of September Preqin pegged global direct lending dry powder at USD171.5 billion, compared with USD1.32 trillion sitting in equity funds, much of which will be invested in mid-cap deals. Being in the largest leveraged buyout market in the world, there is little standing in the way of US direct lending deployment in 2022.

Managers of private capital are becoming more aware of environmental, social and governance (ESG) concerns and direct lenders are no exception. We spoke with Richard Normington, legal director, debt finance, at DLA Piper to discuss how this emergent trend is developing and what to expect in the future.